What is a 401(k) and, more importantly, why should you care? Since this type of investment account first arrived on the retirement planning scene almost four decades ago, it's grown into the most used employer-sponsored retirement plan in the country. More than 52 million Americans have 401(k) accounts, together holding $4.8 trillion in assets as of 2016, according to research from the Investment Company Institute.
These flexible plans can make saving for retirement easier. Read on to learn what our 401(k) advisors think everyone should know about 401(k) plans.
What is a 401(k) Retirement Plan?
A 401(k) is a type of employer-sponsored retirement plan that allows employees to contribute a chosen percentage of their pay to a savings account. In most cases, the contributions made to the 401(k) are tax-deferred, which means the employee doesn't pay income tax on that money until it's withdrawn or distributed in retirement. Some types of 401(k) plans, such as Roth 401(k)s, are "after-tax" plans. That means the employee pays income on their earnings before contributing to the plan.
401(k) retirement accounts are what's known as defined-contribution plans, or plans in which the account balance is determined by:
- Contributions made
- Investment performance
In most cases, employees aren't required to contribute money. Often, though, an employer will match employees' contributions up to a certain percentage. Employers may also choose to contribute through a profit-sharing feature.
How Much Can I Contribute to my 401(k)?
In 2017, employees may contribute up to $18,000 to their 401(k) plan. Employees over age 50 may contribute $6,000 more in what's known as catch-up contributions. Together, employees and employers may contribute a total of $54,000 per year ($59,000 total for employees age 50 and over.) Employers' contributions may include profit-sharing, non-elective and matching contributions.
How are 401(k) Funds Invested?
Once you and/or your employer contribute to your 401(k), those funds are invested, usually in a portfolio of mutual funds. Investment portfolios may also include stocks, bonds and other assets, as determined by the plan guidelines. Many plans allow you to choose to invest in an index fund, an investment vehicle that
tends to be more diversified and less expensive. Your 401(k) advisor can help you review your options and determine which of the investment vehicles offered best meets your time frame, risk tolerance level and goals. Money grows tax-deferred once invested.
How are 401(k) Funds Distributed?
Unlike an IRA, which can be distributed anytime, one of the following conditions must usually occur in order to trigger 401(k) distributions:
- Employee retires or otherwise leaves employment with the plan-sponsoring employer
- Employee dies or becomes disabled
- Employee experience a qualified hardship, such as paying medical bills
- 401(k) plan is terminated
You can start taking distributions without penalty at age 59 1/2. The funds in a 401(k) plan must be distributed starting when the employee reaches age 70 1/2; if the employee is employed, however, required minimum distributions may be deferred. If you choose to take distributions before age 59 1/2, the funds will be taxed as if they were part of your income and you'll have to pay a 10 percent early distribution fee, unless qualified exceptions as determined by the IRS apply.
In some cases, you may be eligible to take a loan from your plan. This is usually up to the employer; generally, you may withdraw up to 50 percent of your vested balance, and pay the loan back — with interest — within five years.
Your employer or plan administrator will be able to answer specific questions about your plan. For more information about how to effectively utilize your 401(k) to plan for retirement, don't hesitate to speak with a 401(k) advisor.